BlackRock Sovereign Risk Index_June 2011
Transcript of BlackRock Sovereign Risk Index_June 2011
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June 2011
Introducing the BlackRock Sovereign Risk Index:
A More Comprehensive View of Credit Quality
A Publication o the BlackRock Investment Institute
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Executive Summary
} Investors are waking up to the signicance o sovereign credit risk in global debt
markets, but quantiying the appropriate premium remains dicult.
} In response, we are introducing a transparent and disciplined approach to assessing
credit risk or sovereign debt issuers. The BlackRock Sovereign Risk Index numerically
ranks issuing countries using a comprehensive list o relevant scal, nancial and
institutional metrics.
} The results contain several interesting insights or debt investors, and some very
distinct groupings o countries emerge. The top countries are scally responsible
and institutionally robust Northern European states, and the bottom ones include
the European periphery as well as some emerging markets.
} Our index can be modied to create screened products that could potentially address
some o the problems associated with market-cap- or GDP-weighted indices.
Over the past ew years, global capital markets have become attuned to the idea that
sovereign debt is not “risk ree”. While in reality sovereigns never were devoid o credit
risk, the probability o capital erosion through deault, infation or devaluation has
certainly increased since the Great Recession began. Far rom being a problem particular
to emerging markets, the developed world is actually at the center o the debate on
debt sustainability. Along with traditional interest rate and liquidity premia, compensation
or credit risk is now being built more explicitly into the yields o all countries,
irrespective o their historical deault experience or share o global production.
For investors who try to earn a modest premium above infation by investing in global
sovereign debt markets, a credit event can be catastrophic. Quantiying the appropriate
compensation or this risk has not been an easy task, given the lack o recent
historical experience. The nature o market-value weighted indices, which overweight
large issuers o liabilities, has also impeded price discovery in traded debt markets.
Some market participants have gravitated toward simple measures o credit quality,
such as the government debt/gross domestic product ratio, to guide their investment
decisions. However, these measures only tell part o the story — there are other
actors, such as reserve-currency status or trend growth rates, which are equally
important in assessing the vulnerability o debt to a credit event.
Recognizing the importance o this source o volatility or investors, BlackRock has
developed an index that ranks sovereign debt issuers according to the relative likelihood
o deault, devaluation or above-trend infation. The index attempts to intelligently
summarize and combine the most important actors that go into the analysis o debt
sustainability, using a transparent and disciplined approach.
The BlackRock Sovereign Risk Index goes beyond the standard “debt/GDP” metric,
drawing on a body o research and pool o data that incorporates a much more
comprehensive view o the actors aecting credit quality. In this paper, we discuss
the index ramework and outline the actors that we have selected. We also examine
the results o the exercise, and suggest applications o the index or our clients.
Table of Contents
Assessing the Risks:
Which Factors Matter? .......................... 3
Constructing the Index .......................... 3
Results ................................................... 7
Applications ......................................... 10
Appendix .............................................. 10
Reerences ............................................11
The opinions expressed are those o the BlackRock Investment Institute as o June 2011, and may change as subsequent conditions vary.
[ 2 ] I N T R O D U C I N G T H E B L A C K R O C K S O V E R E I G N R I S K I N D E X
Benjamin Brodsky, CFA
Managing Director
Fixed Income Asset Allocation} [email protected]
Garth Flannery, CFA
Director
Fixed Income Asset Allocation
Sami Mesrour, CFA
Director
Fixed Income Asset Allocation
Not FDIC Insured • May Lose Value • No Bank Guarantee
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Assessing the Risks: Which Factors Matter?
Global debt markets have been vividly reminded recently o how rapidly a nation’s access to
the capital markets can change, and how violently a country can transition rom r isk-ree
to risky status, as the ownership base switches rom newly unwilling holders to opportunistic
buyers. Because this transition can occur so quickly, an awareness o the actors that
might cause a sovereign to approach a tipping point is critical or understanding therisks inherent in sovereign debt.
One popular and readily accessible indicator used to assess a country’s likelihood o paying
back its outstanding obligations in ull and on time is the debt-to-GDP ratio. The debt-to-
GDP fgure conveniently rames the outstanding debt burden o a government in relation
to the annual income generated by the country. The logic supporting this indicator is
straightorward: A higher debt burden implies high costs o servicing that debt, suggesting
that a large share o income over a long period o time may need to be devoted to paying
down that debt.
There are, however, many other actors that can inuence a country’s likelihood o paying
its real obligations in a timely ashion. For example, the term structure and maturity profleo debt may be ar more important than its aggregate size. I a government has sufcient
time to decide how to restructure its debt or establish measures to cut costs, it is signifcantly
less likely to be orced into making a difcult decision. The world’s largest developed
nations may actually enjoy the relative luxury o retooling the productive capacities o
their economies while holding relatively high debt-to-GDP ratios. The United Kingdom,
or example, possesses the ability to engage in recovery and austerity eorts at least in
part because it has a long debt term structure. In contrast, one need only consider how
quickly the Greek debt crisis spiraled out o control to see what can happen when a
country does not have that luxury.
The useulness o an index lies in its ability to pull together a wide variety o relevant
actors in a systematic, transparent way. There are, o course, a multitude o potentially
relevant eatures used by an investor to dierentiate among credits. An index gathers all
the data in one place and assigns relative weights to relevant actors, creating a unifed
ramework or the assessment o credit risk. It creates consistency and allows users to
ocus on other potential issues that are not included in the index — such as news ow
or political developments — when charting an investment strategy.
Constructing the Index
The frst step in constructing the BlackRock Sovereign Risk Index is to identiy and
categorize relevant undamental drivers o credit quality. These actor inputs are at the
heart o the exercise. The drivers used in the index were selected based on academicresearch, sensibility and pertinence. Many o the metrics included are quantitative, and
those dealing with qualitative aspects are expressed numerically.
The BlackRock Sovereign Risk Index
goes beyond the standard “debt/GDP”
metric, drawing on a body o research
and pool o data that incorporate a
much more comprehensive view o the actors aecting credit quality.
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In order to guide this exercise, we created our broad conceptual categories into which
we attempted to place all key actors. The categories are designed to address several o
the most critical questions with respect to debt sustainability:
} Fiscal Space — This category assesses i the fscal dynamics o a particular country
are on a sustainable path. It estimates how close a country is to breaking through a
level o debt that will cause it to deault (i.e., the concept o proximity to distress), andhow large o an adjustment is necessary in order to achieve an appropriate debt/GDP
level in the uture (i.e., the concept o distance rom stability).
} External Finance Position — The actors in this category measure how leveraged a
country might be to macroeconomic trade and policy shocks outside o its control.
} Financial Sector Health — This category considers the degree to which the fnancial
sector o a country poses a threat to its creditworthiness, were the sector were
to be nationalized, and estimates the likelihood that the fnancial sector may
require nationalization.
} Willingness to Pay — In this category we group actors which gauge i a country
displays qualitative cultural and institutional traits that suggest both ability andwillingness to pay o real debts.
The set o actors we include in the model are listed in Table 1, where we place each
driver into a category and provide a short description o its assessed importance in
evaluating sovereign credit risk.
The actors highlighted in Table 1 are certainly not uncontroversial, and raise tough
questions: the relative merits o net debt and gross debt, and the treatment o o-
balance-sheet liabilities; the selection and reliability o data sources; and the balance
between comprehensiveness and simplicity. These issues are generally addressed
using our intuition (i.e. the importance we assign to specifc actors), and, as we
discuss later, we ran market calibrations to test the sensibility o the results.
For each actor, we ranked all o the countries based on a simple “z-score” methodology
using the average and standard deviation o the actor sample. We then weighted the dierent
ranked actors according to the scheme presented in Figure 1, and added up the results
or each country. Finally, we sorted the results to show cross-sectional rankings in order
o strongest to weakest credit quality. We ound it useul to combine the fscal space actors
into two structural measures, “Distance rom Stability” and “Proximity to Distress,” that
summarize the relationship between several important debt sustainability actors. Their
construction can be ound in the Appendix.
As discussed earlier, we categorized all actors into one o our buckets: Fiscal Space,
External Finance Position, Financial Sector Health and Willingness to Pay. Table 1illustrates the categories and shows the weights we assigned to them.
The high correlation between the
BlackRock Sovereign Risk Index and
CDS spreads suggests that we have
identifed signifcant drivers o
sovereign risk, even while avoiding direct inclusion o market-based
measures in the index.
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Table 1: Key Drivers of Credit Quality
Fiscal Space
Debt/GDP This basic measure o fscal capacity is one o the core drivers o the ability to pay. Assuming a roughly constant tax share, the growth rate
o the real income o a country is an important actor in determining the relative difculty o paying or deaulting (through restructuring,
repudiation, dramatic devaluation or above-trend ination). We use net debt, and estimate the fgure rom a variety o sources.
Per Capita GDP Higher absolute levels o per capita income are generally associated with higher levels o sustainable debt, as the economic and institutional
context or borrowing improves urther up the income scale. Richer countries tend to have better gearing ratios between capital and
labor than poorer countries, leading to more stable economies with better income-generating capacity. We benchmark per capita GDP
in purchasing power parity terms as a percentage o the US income level.
Proportion o Domestically-
Held Debt
Who owns the debt can be a crucial consideration because it can skew incentives to pay. As an extreme example, i 95% o a country’s
debt is owed to oreigners, the state may be incentivized to deault because its constituency isn’t directly hurt i it does so.
Term Structure o Debt I a government has sufcient time to decide how to restructure its debt, retool its economy or establish measures to cut costs, it is signifcantly
less likely to be orced into making a difcult decision. A positive debt maturity structure helps lower the likelihood that a liquidity crisis
becomes a solvency crisis. We analyze this likelihood by looking at total debt maturing within two years as a proportion o GDP.
Demographic Prole Since debts are nominal, higher nominal income makes paying o those debts relatively easier. A growing population also means relatively
more ease in creating nominal income. Higher population growth rates are also associated with higher levels o capital productivity. We
use the age dependency ratio (the number o non-workers such as children and retirees in a country as a proportion o that country’s
working age population, aged 15-64) in the year 2030 as a measure o the working-age population dynamic o a nation over time.
Growth and Infation
Volatility
All things being equal, an unstable income stream or a government should mean a higher l ikelihood o deaulting. Stable growth histories
with low volatility o ination suggest that a country will have the ability, year-in and year-out, to service its loan payments and gradually
move towards a sustainable debt level. This is the public-sector equivalent o a bank lending to a customer with steady job income.
Debt/Revenue A country’s tax take is also important — we argue that or a given level o debt, more tax income is better. At same time, we don’t use this
metric exclusively, as taxes that are too high might mean less exibility or the economy and a reduced ability to raise taxes going or ward.
Depth o Funding Capacity As with a avorable debt maturity schedule, easy access to unding markets helps ensure that liquidity crises are less likely. We use the
“Access to Capital Markets” component o the Euromoney Country Risk r anking.
Deault History Given regime changes and the evolution o i nstitutional depth and quality, it is exceedingly difcult to use the past as a predictor o uture
actions on the part o a sovereign. However, there is some evidence that past deaulters are more likely to deault again when compared to
countries with clean payment histories.1 We proxy the historical proclivity towards deault using the incidence o lending arrangements
with the International Monetary Fund since 1984.
Reserve Currency Status Certain countries, by vir tue o their status in world trade, their historical growth perormance and the depth o their fnancial markets, are
the natural recipients o capital ows rom countries looking to increase their reserves o oreign currency. These countries also tend toact as sae havens when markets experience volatility. This “exorbitant privilege” allows them to more easily fnance defcits and debt
loads without incurring the discipline o the markets. We endow the US, Japan and the Eurozone with varying degrees o this status.
Interest Rate on Debt The interest rate on debt is a crucial input when calculating the level o government debt at some point in the uture. I the growth rate o
debt is greater than the growth rate o income (GDP) over a prolonged period o time, a country will need to adjust its spending patterns
(primary balance) to achieve stability in debt/GDP at some point in the uture.
External Finance Position
External Debt/GDP (Net o
Foreign Exchange Reserves)
The currency in which debt is owed can be important or a sovereign, as it may limit options or repayment. I debts are denominated in local
currency, a government may have the option to reduce those debts by “printing” money in moderate amounts. This option is unavailable
when the debt is owed in the currency o other countries, which means it must be paid out o oreign exchange reserves or current income
at spot exchange rates. To the extent that reserves are unavailable and a currency has weakened, a liquidity crisis may ensue. As mentioned
in other actor descriptions, liquidity crises have the ability to hasten solvency crises. We also incorporate the term structure o external
debt in this analysis, as well as the size o a banking sector’s external liabilities, in proportion to the sector’s railty. There are instances
o quasi-external debt, where debt may be denominated in local currency but the “option to print” assumption doesn’t hold— Eurozone
members ft such a profle, where the ECB’s activities remain distinct rom the wishes o any individual member state. In such cases, wehave designated a proportion o domestically-denominated debt as external, trending inversely with the inuence the country at hand can
be expected to have on the central bank.
Current Account Position In very general terms, to the extent that a country is a net importer o goods, it will also be a net issuer o liabilities. The bigger the import
ratio o a country, the more vendor fnancing it is likely to require, and thereore the more prone it might be to building up a large debt
load. It is also likely that the country will fnd it more di fcult to use import substitution to increase the competitiveness o its economy.
We consider the current account position as a proportion o GDP, as well as o exports.
1 “The Costs o Sovereign Deault,” Eduardo Borensztein and Ugo Panizza, IMF St a Papers, Vol. 5 6, No. 4, pp. 683-741, 2009.
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Table 1: Key Drivers of Credit Quality (continued)
Financial Sector Health
Bank Credit Quality and Size A weaker banking sector means a higher probability that the liabilities o the sector will be assumed by the sovereign. This risk transer
rom private to public balance sheets can signifcantly increase the debt burden o a government, especially i the size o the banking
sector is large. We use a variety o third-party bank health measures, a composite capital adequacy ratio and a non -perorming loan ratio
to characterize a country’s banking system in terms o quality.
Credit Bubble Risk Countries with rapid growth in private debt loads have been shown to be more prone to enter asset price bubbles. Even i a government’s
ormal liabilities are not large, it may be politically incentivized to step in and bail out an over-stretched domestic private sector. Countries
that experience credit bubbles are also more likely to have weaker bank credit quality.
Willingness to Pay
Political/Institutional
Factors
These actors are designed to capture the “sot,” qualitative aspects o a country’s ability to adequately service its obligations. The actors
intend to capture the willingness— as opposed to the ability— o a country to pay, the exibility o an economy and its capacity or growth,
the transparency o data, as well as a country ’s fscal credibility and commitment to responsible borrowing. These actors are collated
rom a variety o public and private sources and include measures o government eectiveness, legal rights and process, payment delays,
repatriation risk, corruption, democratic accountability, government cohesion, government stability and support, and bureaucratic quality.1
1 We have not yet ound a suitable quantitative measure o “fnancial repression”, a concept we explored in a previous publication (“S overeign Bonds: Reassessing the Risk-Free Rate” BlackRock Investment Institute,April 2011). I a country has a large amount o accumulated savings, those s avings can be used (perhaps involuntarily) to und large government defcits, thus prolonging the sustainability o a given debt load.
There are certainly a number o challenges that arise in conducting
this exercise. For example, how should we best set weights onactors without a reliable historical guide to their importance?
While we considered using historical data, we ultimately chose to
set weights or all the actors using our priors. One difculty in
setting empirical actor weights is, o course, that the deault/
ination/devaluation experience or developed market countries
is extremely limited, and we recognized that neither BlackRock
nor the market believes it is reective o the risks going orward.
In addition, the quality o emerging market data becomes more
questionable running back into the early 1990s and 1980s.
We thereore opted to set the actors according to our priors on
relevance and quality o data, and take comort in their sensibilityby validating the index constituents against their respective spreads
in the sovereign CDS market (see Figure 2). The high correlation
(-0.86) between the index and CDS spreads suggests that we
have identifed signifcant drivers o sovereign risk, even while
avoiding direct inclusion o market-based measures in the index.
Another difculty is the act that the ranking is across countries
rather than absolute. This means that the index attempts to estimate
relative risks, rather than explicit probabilities o deault and
Figure 1: Categories and Weights Behind the Index
Fiscal Space40%
External Finance Position20%
Willingness to Pay30%
Financial Sector Health10%
} Distance rom stability
} Proximity to distress
} Leverage to external
macro or unding shocks
} Risk based on instutional
strength and integrity
Figure 2: Index Scores Exhibit a HighCorrelation to CDS Spreads
1,600
600
800
1,000
1,200
1,400
400
200
0
-2.0 -1.0 0.0 1.0 2.0
F I V
E - Y E A R
C D S
S P R E A D ( B
P S )
BLACKROCK SOVEREIGN RISK INDEX SCORE
Greece
Norway
Venezuela
PortugalIreland
Argentina
Egypt
Italy
HungarySpain
Croatia
Sources: Bloomberg, BlackRock.
} Risk the private sector
represents to the sovereign
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severities o loss. The goal o providing reasonable grounds o comparison across the 44
countries was also a constraint — additional idiosyncratic insight can be determined in
particular countries where there is a greater wealth o data. A list o sources is included
in the appendix.
Results
In the inaugural version o the BlackRock Sovereign Risk Index, published in June 2011,
we included 44 countries. The results are presented in Figure 3 below, with stronger
countries on the let-hand side o the chart and weaker ones toward the right.
Figure 3: The BlackRock Sovereign Risk Index
2.0
1.0
0.0
-1.0
-2.0
N o r w a y
S w e d e n
F i n a l n d
S w i t z e r a l n d
A u s t r a l i a
C a n a d a
C h i l e
D e n m a r k
S . K o r e a
G e r m a n y
N e t h e r l a n d s
N e w Z e l a n d
A u s t r i a
C h i n a
T h a i l a n d
U S A
M a l a y s i a
R u s s i a
C z
e c h R e p u b l i c
P e r u
I s r a e l
U K
I n d o n e s i a
F r a n c e
P h i l i p p i n e s
J a p a n
B r a z i l
B e l g i u m
C r o a t i a
C o l o m b i a
I n d i a
P o l a n d
S . A f r i c a
M e x i c o
S p a i n
T u r k e y
I r e l a n d
A r g e n t i n a
H u n g a r y
I t a l y
V e n e z u e l a
P o r t u g a l
E g y p t
G r e e c e
B L A C K R O C K
S O V E R E I G N R
I S K
I N D E X
S C O R E
Sources: IMF, Eurostat, Bloomberg, World Bank, United Nations, BIS, Central Bank Websites, Consensus Economics, EIU, Euromoney, PRS Group, Moody’s, Standard and Poor’s, Fitch.
Topping the index is Norway, which benefts rom extremely low absolute levels o debt,
a strong institutional context and very limited risks rom external and fnancial shocks.
A natural corollary to the country’s low debt level is a relatively small amount o bonds
available or purchase in the debt markets. At the bottom o the rankings lie Greece and
Portugal, whose debt levels appear to be unsustainable at current levels o growth and
expenditure behavior. Along with those two countries, the index also highlights Ireland,
Hungary, Italy, Egypt and Venezuela as signifcantly below-average credits. O course,as the data evolves, and as we add new countries, the rankings will change.
The two most topical countries this year, Ireland and Greece, both score poorly in the
index— no great surprise, certainly. However, they do so or dierent reasons — Greece’s
debt sustainability problems are a result o the fscal dynamics o the government, whereas
Ireland’s problems are primarily related to the size and quality o its banking sector.
Therein lies one o the most valuable eatures o this index: the ability to explore in detail
the drivers o a specifc country’s rankings. For example, the UK is marginally weak in
comparison with the other countries in the index. While the country’s institutional
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strength and integrity is notable, and it is insulated rom external
fnancial shocks, its weakness is attributable to a weak fscal
space profle, while contingent liabilities to the fnancial sector
also drag (See Figure 4).
Figure 4: Components of the UK’sSovereign Risk Score
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0.5
0.0
-0.5
-1.0
Fiscal
Space
Score
External
Finance
Position Score
Willingness
To Pay Score
Financial
Sector
Health Score
Final
Score
B L A C K R O C K
S O V E R E I G N
R I S K
I N D E X
S C O R E
Sources: IMF, Eurostat, Bloomberg, World Bank, United Nations, BIS, Central Bank Websites, ConsensusEconomics, EIU, Euromoney, PRS Group, Moody’s, Standard and Poor’s, Fitch.
Drilling down into the UK’s low scores shows that the continuing
high primary structural defcit is core to the country’s poor fscal
space profle. Proximity to distress also drags, but to a lesser degree.
Within the Financial Sector Health Score, the principal risk is the size
o the potential contingent liability the banking sector poses relative
to the state. In addition, the UK’s growth o credit has outpaced
GDP in recent years, a hallmark o a bubble (Figures 5 & 6):
Figure 5: UK Fiscal Space Subcomponents
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0.5
0.0
-0.5
-1.0
Proximity
From Distress
Distance
From Stability
Fiscal
Space Score
U N I T E D
K I N G D
O M F
I S C A L
S P A C E S U B C O
M P O N E N T S
Sources: IMF, Eurostat, Bloomberg, World Bank, United Nations, Central Bank Websites, Consensus Economics,EIU, Euromoney, Moody’s, Standard and Poor’s, Fitch.
Figure 6: UK Financial SectorHealth Subcomponents
1.0
0.0
-2.0
-1.0
-3.0
Financial
Sector Debt
As a % of GDP
Capital
Adequacy
Banking
Sector
Risk
Credit
Bubble
Risk
Financial
Sector
Health Score
U N I T E D
K I N G D O M F
I N A N
C I A L
S E C T O R H E A L T H
S U B C O M P
O N E N T S
Sources: Bloomberg, World Bank, Moody’s, Standard and Poor’s, Fitch.
Belgium presents another interesting profle, ranking urther down
our index than its agency rating ranking (AA+) might suggest. Unlike
the UK, there is no contingent overhang o liabilities rom the
fnance sector, but the other actors are signifcant drivers or
sovereign risk.
Figure 7: Components of Belgium’s SovereignRisk Score
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0.0
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-2.0
Fiscal
Space
Score
External
Finance
Position Score
Willingness
To Pay Score
Financial
Sector
Health Score
Final
Score
B L A C K R O C K
S O V E R E I G N
R I S K
I N D E X
S C O R E
Sources: IMF, Eurostat, Bloomberg, World Bank, United Nations, BIS, Central Bank Websites, ConsensusEconomics, EIU, Euromoney, PRS Group, Moody’s, Standard and Poor’s, Fitch.
Looking to the subcomponents o fscal space, Belgium’s proximity
to distress is a dragging actor, accentuated by high rollover
requirements in the near term (38% o GDP over the next two
years) and a low domestic investor base (41% o government debt
is held domestically). The distance rom stability actor ares no
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better; under these assumptions, the primary defcit would have
to correct 3.4% on average every year or current net debt levels
to return to 60% over the next 10 years.
Figure 8: Belgium Fiscal Space Subcomponents
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0.0
-0.5
-1.0
ProximityFrom Distress
DistanceFrom Stability
FiscalSpace Score
B E L G I U M F
I S C A L
S P A C E S U B C O M P O N E N T S
Sources: IMF, Eurostat, Bloomberg, World Bank, United Nations, Central Bank Websites, Consensus Economics,EIU, Euromoney, Moody’s, Standard and Poor’s, Fitch.
Figure 9: Belgium External Finance PositionSubcomponents
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-1.0
-2.0
External Debt
Less Foreign
Reserves/GDP
External
Debt Term
Structure
Current
Account
External
Finance
Position Score
B E L G I U M E X T E R N A L F I N A N C E
P O S I T I O N
S U B C O M P O N E N T S
Sources: Bloomberg, BIS, Moody’s, Fitch, Consensus Economics, PRS Group.
Figure 10: Components of Italy’s Sovereign
Risk Score1.0
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Fiscal
Space
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External
Finance
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Willingness
To Pay Score
Financial
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Final
Score
B L A C K R O C K
S O V E R E I G N
R I S K
I N D E X
S C O R E
Sources: IMF, Eurostat, Bloomberg, World Bank, United Nations, BIS, Central Bank Websites, ConsensusEconomics, EIU, Euromoney, PRS Group, Moody’s, Standard and Poor’s, Fitch.
The external fnance position has the biggest negative eect
on Belgium’s score, however. As a small country within the
Eurozone, Belgium has a substantial quasi-external debt
exposure, with a high rollover burden over the next two years.
Given the euro denomination o this debt, it has not amassed
signifcant oreign reserves, which leaves it with ew options
should a liquidity crisis arise.
At present, these negative actors are compensated by a high
willingness to pay score, but confdence in the country’s institutional
integrity may yet be eroded by continuing problems in government —
Belgium has been without an ofcial government since its last
elections on June 13, 2010.
Another interesting case ramed by this approach is Italy. At101% o GDP, its net debt is extremely high or a country with its
undamentals and term structure (it needs to roll approximately
43% o its GDP in debt over the next two years), so its proximity
to distress is ar rom grounds or comort.
Although Italy is expected to run a primary budget surplus this
year, the interest it pays on its existing debt, against a backdrop
o anaemic long-term growth projections and an aging demography,
signifcantly impedes a path to stability.
Turning to vulnerability to external fnance shocks, Italy runs a
persistent current account defcit, and its position within theEurozone means it does suer rom quasi-external debt exposure
and cannot “print” itsel out o difculties i they arise.
Other actors drag— though to a lesser degree — on Italy’s sovereign
risk: institutional integrity metrics are weak relative to its peers,
and the capital adequacy o its banking sector also compares
badly (though the fnancial sector does not present a large-scale
contingent liability or the economy as a whole).
Taking these points into consideration, we believe that Italy may
be a case where markets are too sanguine about sovereign risks,
and would be inclined to be deensive on this market within an index.
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[ 10 ] I N T R O D U C I N G T H E B L A C K R O C K S O V E R E I G N R I S K I N D E X
Applications
We believe that the BlackRock Sovereign Risk Index can be used to meet a variety o
needs and act as an efcient aid to risk-adjusted security selection. For investors looking
to maintain exposure to global debt markets, but also wishing to improve the tail-risk
characteristics o market- or GDP weighted indices, the index can help screen specifc
exposures. Alternatively, the index can also be used to guide strategic tilts into or out oall names in an existing index.
Another interesting application could be to use the index as the basis or an investable
benchmark. This exercise would require an adequate liquidity screen to ensure there
is appropriate oat in the issuers o sovereign debt, in order to make the index
realistically investable.
Using the index as a predictive tool or outperormance year-in and year-out may prove
difcult, and using a undamental model to predict technical or political developments
can be tricky. But as a more intelligent way o gaining exposure than traditional indices,
or as a low-cost means o buying insurance against drawdowns, an approach like the
one we detail may be useul. What is clear to us is that investors can certainly beneftrom a more sophisticated approach to the sovereign debt markets. The BlackRock
Sovereign Risk Index has been devised to help investors identiy and manage risk in
a consistent and disciplined ashion. We believe that this index highlights BlackRock’s
commitment to helping ensure a better fnancial uture or our clients.
Appendix
Our Fiscal Space category contains two dierent, equally-weighted measures designed
to summarize a series o actors. The measures are are: “Distance rom Stability” and
“Proximity to Distress.”
Distance rom stability asks the question: Given orecasted growth and interest rates,how much adjustment is necessary in primary balances to achieve a stabilized debt/
income at or below a sustainable debt level? It represents the structural adjustment in
spending and tax patterns needed rom this point on to achieve a stable and appropriate
debt/GDP level in 10 years. The stylized ormulation o this measure is shown in Box 1.
Box 1: Distance from Stability
Fiscal Distance = Annual Primary Balancet– Annual Paydown Requirement
Where
Annual Paydown Requirement = (Target Debt/GDPt+10
– Debt/GDPt+10
)
10
Target Debt/GDPt+10
= 60% or High-Income Countries30% or Low-Income Countries
Debt/GDPt+10
= ((g –r)*Debtt) * 10
(GDPt * g) *10
and
g = Forecasted Growth Rate
r = Forecasted Interest Rate
As a more intelligent way o gaining
exposure than traditional indices, or as
a low-cost means o buying insurance
against drawdowns, an approach like
the one we detail may be useul.
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[ 11A P U B L I C A T I O N O F T H E B L A C K R O C K I N V E S T M E N T I N S T I T U T E
Proximity to distress is a slightly di erent approach to stability using several additional
actors. It asks the question: At the current “burn rate” o budget defcits, how long does
a country have beore it reaches a breaking point beyond which it will be very unlikely to
recover without deaulting? The stylized ormulation o this measure is shown in Box 2:
References
Borensztein, Eduardo, and Panizza, Ugo, October 2008, “The Costs o Sovereign
Deault,” IMF Sta Papers, Vol. 56, No. 4, (Washington: International Monetary Fund).
Manasse, Roubini, and Schimmelpennig, November 2003, “Predicting Sovereign Debt
Crises,” IMF Working Paper No. 03/221 (Washington: International Monetary Fund).
Hemming and Petrie, March 2000, “A Framework or Assessing Fiscal Vulnerability,”
IMF Working Paper No. 00/52 (Washington: International Monetary Fund).
Augustine, Maasry, Sobo and Wang, April 2011, “A Sovereign Fiscal Responsibility Index,”
SIEPR Policy Brie (Stanord, CA: Stanord Institute or Economic Policy Research).
Ramanarayanan, September 2010, “Sovereign Debt: A Matter o Willingness, Not Ability,
to Pay” Economic Letter, Vol. 5, No. 9 (Dallas: Federal Reserve Bank o Dallas).
Box 2: Proximity to Distress
Proximity to Distress, Years = Fiscal Space / Latest Budget Defcit as % o GDP
Where
Fiscal Space = Maximum Debt/GDP – Current Debt/GDP
Maximum Debt/GDP = ƒ(GDP Per Capita) * ƒ(Demographic Profle, Term Structure oDebt, Domestic Ownership Structure, Debt/Tax Revenue, Growth/Ination Volatility,Access to Funding, Previous Deaults, Reserve Currency Status)
About The BlackRock
Investment Institute
The BlackRock Investment Institute is a
global platorm that leverages BlackRock’s
expertise in markets, asset classes and
client segments to generate investment
insights that seek to enhance the frm’s
ability to create a better fnancial uture
or clients. Launched in 2011, the Institute
hosts a series o events through the
BlackRock Investment Forum that oster
debate around key investment themes.
The Institute’s goal is to produce a ow
o inormation that makes BlackRock’s
portolio managers better investors and
helps deliver positive investment results
or our clients.
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